Earlier this week, the Canadian government received a vote of no-confidence, effectively bringing an end to months of allegations that Canada’s ruling Liberal Party was corrupt. As a result, the Canadian Parliament will be dissolved, and a snap election will be held at the end of January. In the past, currency traders have responded to episodes of political uncertainty be selling that nation’s currency. In this case, however, the Canadian Dollar was virtually unaffected. Canada’s economy continues to outperform on the heels of strong exports and lofty commodity prices, and its Central Bank is set to hike interest rates again next week. Reuters reports:

“With underlying support for the loonie from developing M&A deals, the geopolitical risks are still seen as taking a backseat to positive flows and fundamentals,” said [a senior currency strategist.]

Read More: Canadian dollar helped by GDP data, energy prices

In the last few weeks, many currency traders had begun to shift their attention in favor of the Euro, based on the expectation that the US-EU interest rate differential would soon narrow. That all changed yesterday, as economic data underscored support for monetary tightening. Specifically, the data showed a record month for new home sales, suggesting the housing market and even the US economy are still buoyant. As a result, currency traders and economists are predicting that the Fed will now hike rates three more times, which represents a change from the previous consensus of two times. If the Fed fulfills these expectations, you can expect the USD to continue outpacing the Euro in the near-term. The Financial Times reports:

“The US will be tightening more than the market thinks, and while the ECB will hike this week, we don’t think there will be a follow-up hike until June.”

Read More: Rise in US home sales lifts dollar

In many branches of economics, there is a significant divergence between theory and reality. This is especially true of exchange rate economics, where empirical evidence suggests that theory is of little use in explaining and forecasting exchange rates. Basically, currency traders may fare better flipping a coin than using theories of interest rate parity and purchasing power parity as basis for their trades. In contrast, data on foreign exchange market-makers order flow has proven to be extremely insightful. The books of Citibank, for example, can be used to make reasonably accurate predictions for the future direction of exchange rates, based on the ratio of buyers to sellers. Technical analysts rejoice! The Economist reports:

The information in today’s order flow will still be percolating through the market weeks afterwards…Citibank’s order flow can predict almost 16% of the dollar’s bobbing and weaving four weeks hence.

Read More: Marking the dealer’s cards

The US Treasury Department finally released its annual currency report; which contained a notable absence: China. Politicians and lobbyists were outraged that the Bush Administration did use the report to formally accuse China of manipulating its currency. Senators Schumer and Graham are already threatening to reintroduce a bill that would slap a 27.5% tariff on all imports from China. Secretary of the Treasury, John Snow, tried to brush off criticism that the administration was being too soft on China, by publicly urging China to move forward on plans to continue adjusting the Yuan, which has appreciated only .3% in the last four months. The Associated Press reports:

We are looking to Congress,” Tonelson said. “It is clearer than ever that America’s domestic manufacturers cannot count on any help from the White House to remedy this totally unacceptable situation.”

Read More: U.S. criticized over China currency report

Canada’s economy grew at 3.8% in 2005 Q3, marking its fastest quarter of growth in over a year. The Canadian economy has historically been driven by exports of commodities. In this latest quarter, however, retail sales data indicate consumers have started to pick up some of the slack in the economy. As a result, Canada’s Central Bank has hinted that it will further raise short term interest rates from the current level of 3%. Currency strategists will likely remain bullish on the Canadian Dollar, as longs as its economy continues to hum and the differential between Canadian and US interest rates continues to narrow. Bloomberg News reports:

Yields on interest-rate futures indicate traders expect the central bank will raise its benchmark rate a quarter percentage point…on Dec. 6 and Jan. 24. The yield on the March futures contract was 3.86 percent, about the highest this year.

Read More: Canada’s Dollar Poised for Biggest Weekly Advance Since July

Perhaps in response to recent pressure from American politicians and the IMF, the Central Bank of China made another push towards floating the Yuan by introducing foreign exchange swaps. Swaps function like futures, by enabling partied to buy and sell currencies at a fixed exchange rate on a fixed date in the future. In this case, the Central Bank has agreed to buy USD one year from now at a rate of 7.85 Yuan/USD. Investors and analysts are speculating that the swaps lend explicit insight into where the Central Bank believes the Yuan will be in one year. Non-deliverable forward contracts, which indicate collective investor expectations for the future value of the Yuan, are currently priced at 7.78 Yuan/USD. The China Daily reports:

Late Thursday, China’s State Administration for Foreign Exchange announced it would also introduce a new currency trading system allowing interbank market members to trade directly with each other.

Read More: Central bank pushes foreign exchange reform

Last week, this correspondent reported that American politicians, frustrated by their inability to convince China to further revalue the Yuan, were planning on using the IMF as a vehicle for applying pressure to China. Yesterday, the IMF fulfilled this request during a conference call with Chinese officials. IMF representatives referred to the Yuan’s marginal .33% rise since the July revaluation in their plea for China to allow its currency to respond to market forces. Apparently, the IMF has been working closely with Chinese officials since 1999 on issues related to foreign exchange. The organization now feels China has the necessary infrastructure in place to support a more flexible Yuan. Reuters News reports:

“Greater exchange rate flexibility would contribute to rebalancing the composition of economic growth…and potentially raising consumption by boosting households’ real income,” said the director of the IMF’s Asia-Pacific department.

Read More: IMF presses China; says yuan movements too limited

For the last few years, policymakers around the world have publicly griped over the trade surpluses of emerging Asian economies, which may collectively approach $200 Billion this year. Perhaps they should shift their attention to the oil-exporters, which are expected to collectively record a current account surplus exceeding $400 Billion. Thus far, OPEC nations have ‘equalized’ their massive surpluses by recycling their oil profits into dollar-denominated assets. However, many analysts reckon this will only hold in the short-term. As oil exporters become accustomed to high oil prices and proportionately large current account surpluses, they will likely invest the proceeds at home in domestic assets and infrastructure projects. They may also diversify their foreign exchange reserves into Euros, in order to mitigate the risk of a weakening dollar. The Economist reports:

Russia’s central bank has reduced the share of dollars in its foreign reserves over the past couple of years, but it is still around 65%. The central bank has said that it wishes to hold more euros.

Read More: Recycling the petrodollars

The Federal Reserve recently released the ‘minutes’ from its last meeting, lending insight into the near-term future of American monetary policy. The minutes reveal some uncertainty as to when the Fed will stop raising interest rates, which currently stand at 4%. Prior to the release of the minutes, investors had priced in 3 additional rate hikes, which would lift the benchmark federal funds rate to 4.75%. However, it appears the Fed is becoming increasingly nervous that economic growth is slowing. As a result, interest rate futures indicate that investors now believe there is a 68% chance that the Fed will stop tightening at 4.5%. Likewise, currency traders are reevaluating their forecasts for the USD, which will further suffer if the ECB moves to close the interest rate gap between the EU and the US. Bloomberg News reports:

“Yield is playing an important part in currency Markets,” said Greg Gibbs, senior currency strategist at RBC Capital Markets in Sydney. “The dollar will give up some of its strength.”

Read More: Dollar May Weaken After Fed Signals Rate Increases to End Soon

Last week, Jean Trichet, president of the European Central Bank (ECB), insinuated that investors could reasonably expect the ECB to begin raising interest rates, possibly as soon as December 1. While testifying before the European Parliament’s Committee on Economic and Monetary Affairs, however, he backtracked from his earlier comments, by stating that investors should not expect a “series of rate hikes.” While the exact meaning of his comments is debatable, it seems investors should no longer take monetary tightening for granted. If the ECB raises interest rates at all in the short term, it is likely to do so only once or twice in order to give the economies of the EU plenty of time to adapt to a rising interest rate environment. Meanwhile, currency traders are furious at Trichet for the excessive volatility he injected into forex markets.

Read More: Euro’s gains fade as Trichet reins in rate hopes

Despite its best efforts, the US has not any success in convincing China to further appreciate the Yuan, since the monumental revaluation in July. Meanwhile, American politicians are toying with the idea of legislating a tariff on all Chinese imports, and trade groups are lobbying for the Treasury Department to officially label China a ‘serial currency manipulator.’ Lately, however, those in favor of Yuan revaluation have embarked on a new strategy, by attempting to enlist the help of the IMF (International Monetary Fund) in applying economic and diplomatic pressure to China. They are suggesting the IMF use its clout to hold a special economic consultation with Chinese officials, and demonstrate that it is in the best interest of everyone that China further loosens the Yuan. The Wall Street Journal reports:

“Movement to a market based exchange rate would be in [China’s] interests,” Deputy Treasury Secretary Robert Kimmit said in an interview. “It would also serve our-and global- interests.”

Read More: Bush Team Urges IMF to Press China for Strengthening of Yuan

Due primarily to lackluster investment and economic growth, inflation has not concerned EU central bankers in recent years. Core inflation is a meager 1.3%, well below the EU benchmark interest rate of 2%. Now, however, rising energy prices have begun to affect consumer spending habits as well as raised production costs for many businesses. A great deal of circulation has swirled over whether the ECB will preemptively head off inflation by hiking interest rates at its December meeting. The consensus among economists and EU officials is of overwhelming support for a rate hike for such inflationary reasons. Today, Jean Trichet, President of the ECB confirmed the inevitability of a rate hike, which provided support for the Euro. The Financial Times reports:

Trichet said the ECB was “ready to take a decision to move interest rates and moderately augment the present level of intervention rates in order to take into account the level of risks to price stability”.

Read More: Euro fights back as Trichet signals rate hike

This week, Japan witnessed a feud with potentially far-reaching implications, as the Bank of Japan argued with LDP politicians over who has control of Japanese monetary policy. The spat began, when the Bank of Japan hinted publicly that it would like to reassert its independence in matters of monetary policy and hike interest rates. The announcement worried Japanese politicians for a couple of reasons. First, the popularity of the ruling LDP is closely tied to the performance of Japan’s economy; accordingly, LDP politicians want to be certain the economy is on solid footing before they adjust interest rates. Second, Japan has run massive fiscal deficits in recent years, and higher interest rates would raise the government’s cost of borrowing. Yen bulls should monitor this situation closely, for a hike in Japanese interest rates could provide an impetus for the Yen to reverse its systemic decline.

Read More: Japan’s Divided Policymakers

In September, foreigners collectively purchased $110 Billion in US assets, which represents a monthly record. Economists had expected net foreign purchases to total only $70 Billion, based on the logic that an appreciating USD would deter foreign investment. Fortunately, it seems members of OPEC and Asian exporters continue to reinvest their trade surpluses into US denominated assets. Dollar bulls have drawn support from the news, using it as evidence that foreigners are nowhere near tired of owning US assets. Bloomberg News reports:

“This number is going to add to the dollar’s upward momentum,” said the head of global currency strategy at RBC Capital Markets Ltd. in London. “The dollar is benefiting from increased risk appetite among foreign investors, particularly for equities.”

Read More: Dollar Rises as Foreign Buying of U.S. Assets Surges to Record

On a quarterly basis, the GDP of the collective Euro-zone economies grew by .6%, which is equivalent to an annualized growth rate of 2.4%. The EU economies were boosted by strong German export growth as well as higher-than-expected French consumption. Meanwhile, oil prices remain at elevated levels, and inflation is rearing its ugly head. Economists will likely point to this news as evidence of an EU-wide economic recovery, and argue that the rising possibility of inflation should impel the ECB to preemptively raise rates. The Financial Times reports:

“The momentum of ECB opinion swinging in favour of higher interest rates now looks unstoppable,” said Julian Callow, an economist at Barclays Capital in London. “We now expect the ECB to raise rates 25 basis points on December 1.”

Read More: Eurozone growth ups chances of rate increase

It is expected this quarter will marl the fourth consecutive of increasing economic growth in Japan. Accordingly, economists no longer believe deflation represents a threat; in fact, most economists are predicting core price inflation will exceed .5% this year. Japanese central bankers have responded to the prospect of rising inflation by suggesting an increase in short term interest rates, which are currently 0%. In Japan, however, the political establishment has just as much control in setting monetary policy as the Central Bank. In this case, Japanese politicians would like to make sure the Japanese economy is on solid footing before interest rates are hiked. Currency traders have not responded favorably to a prolonged period of easy money, as evidenced by the Yen’s continued decline. The Financial Times reports:

[One economist] believes year-on-year Japanese inflation is about to turn positive, as sharp falls in the price of mobile phones, electrical items and rice a year ago drop off the index. However, with the sustainability of this trend in doubt, he sees rates remaining at, or very close to, zero until April 2007 at the earliest.

Read More: Yen falls on battle over monetary policy

In the next few years, a bevy of eastern European countries are scheduled to adopt the Euro, and EU officials are already beginning to make the appropriate preparations. Estonia will be first (2007) followed by Slovakia (2008) with Latvia, Lithuania, Slovenia, Czech Republic, Hungary, and Poland slated to adopt shortly thereafter. While the economies of eastern Europe are small in comparison to those nations currently on the Euro, their presence will nonetheless be felt for an important reason: inflation. The collective economic stagnation of western Europe has resulted in low rates of domestic inflation. The economies of eastern Europe, in contrast, have boomed in the last few years, spurring high rates of inflation. Once these nations adopt the Euro, the ECB may begin to think critically about the risks posed by inflation. The Economist reports:

Estonia, due to adopt the euro on January 1st 2007, is a rare economic star by the debt-drenched, slow-growing standards of the euro zone. Whereas growth in the euro area is well under 2%, Estonia’s economy last quarter expanded at a cracking 9.9% annual rate.

Read More: Flights to Frankfurt

Next week, George Bush will visit China as part of his week-long junket to Asia, in which it is expected he will personally urge Hu Jintao, Prime Minister of China, to continue revaluing his nation’s currency. Bush is under pressure from unions and trade lobbyists, who allege China’s artificially cheap currency is responsible for the outsourcing of millions of jobs. American politicians are demanding that Bush give China an ultimatum: either revalue, or face the consequences, in the form of tariffs and other trade restrictions. In addition, the Treasury Department was supposed to release a report on currencies last month, in which China would likely be labeled a ‘currency manipulator,’ but has delayed the release of the report until after Bush returns from his visit.

“I will remind him that this government believes they should continue to advance toward market-based evaluation of their currency for the sake of the world, not just for the sake of bilateral relations,” Mr. Bush told a group of Asian reporters this week.

Read More: Bush to Press China on Yuan in Visit

In September, the US recorded its worst trade deficit ever, of $66 Billion. The chief causes of the aberrantly large trade deficit were hurricane Katrina, high oil prices, and a strike at Boeing. The closing of ports that occurred during Katrina as well as the strike at Boeing, which combined to reduce net exports by $4 Billion, would seem to be isolated incidents and will not likely impact the balance of trade in the future. Soaring oil prices, on the other hand, may remain high for quite some time, and represent a structural, more pronounced change in the balance of trade. Until members of OPEC decide that they would prefer to hold Euros over USD, however, the Dollar should be safe.

“The trend over time is likely to remain for a wider trade gap generally,” said Ian Morris, US economist at HSBC in New York. HSBC said that the worse-than-expected trade deficit may drag growth in the third quarter down from about 3.8 to 3.4 per cent.

Read More: Hurricanes and oil push US deficit to $66bn

The Brazilian Real surged to a 4 ½ year high against the USD today, on the heels of strong economic growth and stratospheric interest rates. Brazil is currently among the strongest economies in the developing world, often lumped in the same category as China, India, and Russia. Investment in fixed capacity has spurred significant increases in production and exports, and hence, GDP. In addition, Brazil’s federal funds rate currently exceeds 19%, a level that has made foreign creditors all too eager to lend to Brazil. In fact, Standard and Poor’s, an international rating agency, recently raised its rating on Brazilian government bonds, a move which will surely suck in more foreign capital, and provide additional support for the Real. The Financial Times reports:

The real was further aided by a government announcement that it planned to sell more bonds maturing in 2015, a move likely to increase portfolio inflows into Brazil even further. The real has now risen 31.7 per cent against the dollar since May 2004.

Read More: Brazil’s real hits 4 ½ year high

For almost two weeks, France has been plagued by rioting, who have burned vehicles by the thousands and clashed with police. Economists and political analysts are now beginning to asses the political and economic implications of the civil unrest. Several have speculated that the rioting will spread to neighboring European countries, which would significantly disrupt the Euro-zone economy. Currency traders are also beginning to react to the riots, in theorizing that they are indicative of negative sentiment towards the French economy. If these riots are not soon quashed, the Euro will likely continue to suffer. Reuters reports:

“Concerns about the ongoing riots in France, to the extent they are a reflection of the social consequences of prolonged anemic growth in the eurozone, may also be playing some role in limiting the euro’s ability to benefit from improved interest rate support.”

Read More: Dollar reaches 2-year high against euro

As the USD continues to reach fresh highs against major currencies, forex traders are beginning to wonder if and when it will all end. The consensus, to the chagrin of Dollar bears, is that the USD will continue to appreciate, possibly into 2006. Traders cite a few factors. First, the Homeland Investment Act has already spurred the repatriation of $200 billion in foreign profits, a figure which is expected to double before year end. This massive inflow of capital that is currently being held overseas represents an enormous potential boon for the USD. Next, interest rate differentials between the US and other developing nations are expected to widen further before year-end, as part of the Fed’s effort to rein in inflation. Juxtapose this with decreasing prospects for an ECB rate hike, and a picture of a smooth-sailing USD begins to emerge. The Financial Times reports:

Expectations of ever-widening yields between the US and the eurozone played their part, particularly with the latter beset by weak retail sales data that may, at the margin, lessen the scope for eurozone rate hikes.

Read More: Dollar’s strong run continues

In recent years, Asia’s current account surplus with the US has ballooned, and Asian Central Banks’ collective holdings of USD now exceed $2 trillion. While currency traders continue to monitor this situation closely for signs that Asian Central Banks are planning to diversify their reserves, the focus is slowly shifting to the Middle-East, which is expected to run a current account deficit comparable to that of Asia. Thus far, Middle-Eastern countries have been quick to take the proceeds gained from higher oil prices and reinvest them in US Treasury securities, resulting in a net effect of zero on the USD. If oil prices remain high, and Middle Eastern countries find themselves awash in profits, it is extremely likely that they will begin to diversify their foreign exchange holdings, at which point the USD will suffer. The Times online reports:

The Middle East [is now] in the same league as Asian central banks – heavy hitters in the currency markets because of their vast dollar holdings. Traders and analysts routinely scrutinise every word from Asian central bank officials for signs of currency skittishness, and the markets can move dramatically on apparent shifts in sentiment.

Read More: ME takes centerstage in currency markets

Over the last decade, the US economy has grown on average by 3% per year. Over the same period, the economies of the EU have collectively grown by 2%. In a new research paper, two prominent economists have attempted to make sense of this disparity. There theory is multifold, taking into account differences in government, education, and monetary policy. It is a combination of these three structures, they argue, that has driven the US economy to outperform that of the EU, and by extension, the perennial strength of the USD.

First, the US government is largely laissez-faire, meaning it attempts to allow capitalism and free markets to flourish, whenever possible. EU governments, in contrast, have attempted to implement socialist policies within a capitalist framework, including protectionist economic policies and jobs protections, which detract from economic growth. Next, the US government spends more money on education than their EU counterparts, and relatively more Americans have advanced degrees than Europeans. Finally, American policy makers have attempted to use monetary and fiscal policy to smooth business cycles (dampen the highs and raise the lows), whereas EU governments have turned to such tools of economic policy only when their economies need stimulating. The moral of the story is that the US has done a much better job than the EU over the last decade in facilitating economic growth. At the same time, this paper has outlined steps for EU governments to improve their respective economies.

When Jean-Claude Trichet, President of the European Central Bank (ECB), hinted several weeks ago that the ECB was poised to raise interest rates, the Euro immediately jumped almost 2%. Today, however, Trichet sang a different tune, insisting a hike in interest rates was not indeed imminent. The announcement clearly came as a shock to economists and investors, many of whom had predicted the ECB would raise rates for the first time in two years, on the basis of Trichet’s earlier comments. According to the ECB, interest rates are at an appropriate level, whereby inflation is contained without constraining economic growth. Bloomberg News reports:

“Trichet was expected to be quite hawkish, so the euro is being sold on disappointment with the more dovish comments…The market will now be looking for signs that the rate hike [will happen in] December.”

Read More: Euro Drops as Trichet Damps Speculation About Rate Increases

The USD has risen to a 25-month high against the Japanese Yen, including a 14% increase in this year alone. The Japanese economy has begun to show signs of life; its capital markets have performed those in the US, and Japan continues to run a massive current account surplus with the US. Hence, the USD’s continued appreciation against the Japanese Yen, and many other Asian currencies, has forex traders scratching their heads. Economists have turned to data on international capital flows in attempting to explain the weakness of Asian currencies. They believe rising US interest rates combined with the perceived stability of US capital markets are driving risk-averse investors, especially those in Asia, to shift capital into the US, which has generated massive demand for USD. The Wall Street Journal reports:

During the first eight months of this year, Japanese investors have poured $126 Billion into foreign stocks and bonds, up 19% from the same period last year.

Read More: No (Dollar) Gain without Pain

The performance of the collective EU economy has been nothing short of pathetic in the last few years, and is set to grow at only 1.5% this year. As the current leader of the EU, British Prime Minister Tony Blair has been charged with spearheading the Euro-area economic turnaround. He has proposed a comprehensive plan for structural reforms, including less job security, fewer social safety nets, and government subsidized spending on research & development. It has been theorized that the socialized policies of the EU create few incentives to work and have resulted in massive unemployment. If EU member countries eliminate certain job protections, thereby restoring this incentive to work, it may ignite their respective economies and spark the Euro in the process. The Economist reports:

Growth has consistently lagged behind America’s in recent years, particularly in continental Europe, where unemployment rates often hover near double digits (well above 10% in the cases of Germany and Belgium).

Read More: When growth and social protections clash

The Federal Reserve voted today to raise the benchmark federal funds rate by 25 basis points to 4%, which represents the 12th consecutive rate hike. As expected, the USD received broad support from the announcement, as interest rate differentials among developed nations increasingly favor the US. However, since the Fed has made an effort to increase transparency by telegraphing interest rate hikes, this move came as no surprise to most investors. Moreover, it is expected that the Fed will continue to raise its interest rate until it reaches 4.5%. While each successive rate hike will lead more risk-averse investors to shift capital to the US, the future rate hikes have already been priced into the USD and will not likely be enough to lift the USD out of its trading range. The Financial Times reports:

RBC Capital Markets argued that “rising US rates alone will not guarantee further broad based appreciation in the dollar, especially if yield appetite declines and/or risk aversion climbs markedly”.

Read More: Dollar stays near two-year high after Fed